Verizon Communications Inc. (VZ) Q2 2011 Earnings Report, Transcript and Summary

Good morning, and welcome to the Verizon Second Quarter 2011 Earnings Conference Call. [Operator Instructions] Today's conference is being recorded. If you have any objections, you may disconnect at this time. It is now my pleasure to turn the call over to your host, Mr. John Doherty, Senior Vice President, Investor Relations for Verizon.

Thanks, Brad. Good morning, and welcome to our second quarter 2011 earnings conference call. Thanks for joining us this morning. I'm John Doherty. With me this morning are Fran Shammo, Verizon's Chief Financial Officer; and Lowell McAdam; Verizon's newly-elected President and Chief Executive Officer effective August 1. Before we get started, let me remind you that our earnings release, financial and operating information, the investor quarterly and the presentation slides are available on our Investor Relations website. This call is being webcast. If you would like to listen to a replay, you can do so from our website. I would also like to draw your attention to our Safe Harbor statement. Information in this presentation contains statements about expected future events and financial results that are forward-looking and subject to risks and uncertainties. Discussion of factors that may affect future results is contained in Verizon's filings with the SEC, which are available on our website. This presentation also contains certain non-GAAP financial measures. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are also on our website. Before we get started, I'd like to point out that our second quarter includes the results of Terremark since the acquisition closed in early April. As we go through the presentation, we will point out the effects on certain growth rates as appropriate. With that, I will now turn the call over to Fran.

Thanks, John, and good morning, everyone. Before we get into the details, let me start with some brief overview commentary adding my perspective to our second quarter results. We had a very strong quarter, continuing the positive momentum from earlier this year. Our results clearly demonstrate that we are executing well in our key areas of focus and driving profitable growth. Our top line revenue growth accelerated to 6.3% year-over-year, which is a 100 basis point increase from our first quarter growth rate of 5.3%. This was our strongest quarter of consolidated revenue growth in 2.5 years. In Wireless, we had an outstanding quarter of customer growth, with strong demand for smartphones and Internet data devices and increasing service revenue, driving total revenue growth of 10.2%. We also saw continued improvement in Wireline revenue, with higher Global Enterprise revenue driven primarily by improvements in Strategic Services. EBITDA margins this quarter expanded sequentially in both Wireless and Wireline, as we continue to focus on driving top line growth as well as improving our operating efficiency. In Wireless, our EBITDA service margin expanded 170 basis points from first quarter to 45.4%, an impressive result in light of increased postpaid customer growth, continued smartphone penetration and Internet device expansion. In Wireline, the EBITDA margin increased by 20 basis points to 23.8%, our fifth consecutive quarter of margin improvement, through a combination of better revenue performance and our continued focus on cost containment. Our second quarter earnings of $0.57 per share is a very solid result, up from $0.51 in the first quarter and demonstrates good execution and the strength of our business model and the strategy that we discussed with you back in January. With that, let's begin a more detailed review of the quarter on Slide 4 starting with consolidated results. As…

Thank you, Fran, and good morning everyone on the call. Today is obviously an important day for Verizon as we transition the CEO role from Ivan to me. This has been a very smooth transition by any measure, and we have Ivan to thank for that. He has had a very clear plan from the beginning, and that is to keep the focus on customers and our investors. I want to be sure that I say to investors on my first day on the job that I understand the obligations that come with this position and that is to deliver bottom line results. Ivan has built a tremendous company over his 18 years of leadership. He has moved this business from a regional wireline voice business to the leading national wireless company and to a Global Enterprise technology company. I believe we can accelerate that transformation to a global solutions and networking company. I believe that the pieces are already in place to do that, and that we are showing good momentum in our results to further fuel that transformation. Morning Fran has done his usual highly professional job explaining the results. A few things stand out for me. First, Wireless continues to show strong growth and industry-leading profitability. We have been through many transitions of devices and technology. The consistency of results in the face of a highly competitive and dynamic market show the underlying strength of our team and our operations. Second, the FiOS strategy has proven itself by taking share and gaining revenues. Our enterprise strategy, fueled by the MCI, the Cybertrust and now, the Terremark acquisition, is producing a highly-successful portfolio of services that are being rapidly adopted by our customers. And finally, I see a cost-control mindset that is driving overall profitability. While my optimism…

Thanks, Lowell. Brad, that concludes our opening segment of the call. Let's open it up for questions.

[Operator Instructions] Our first question will come from John Hodulik of UBS.

I guess the question is for Fran. I'm trying to maybe get a sense for the trends in Wireless ARPU and basically what happened between the 2.8% growth in margin and what we saw in the first quarter. It sounds like -- for the second quarter, it sounds like it's a mix -- it's a combination of increased mix of connected devices and some ARPU pressure within each category. And specifically, you mentioned that the migration from 3G to 4G putting pressure on ARPU because those are lower-priced devices. If you could give us a sense for maybe the magnitude of which one was the larger of the drivers. And two, maybe how far through that migration of customers from 3G to 4G ROE, how much more pressure do you expect from that specific issue? And maybe give us a sense for what you expect for ARPU trends going forward in the postpaid side.

John, so this is -- I'm glad the question came because this is one that's important. So if you look at -- we've actually disclosed the new metric that we now call phone ARPU, which consists of our smartphones and our feature phones. And again, this quarter, we saw a very good uptick from feature phone to smartphone, about 53% with the Apple phone, transforming from the feature phone into the smartphone. So we're seeing that 3.2% continuing into the future. I think the important thing here is though is on the Internet devices, and it's important to know because if you go back to October of last year when the market changed pricing on all of Internet devices, we actually launched Internet pricing at $35 per 3 gig; $50 for 5 and $80 for 10. And as we saw the market and we expanded the market in this category with also the innovation of the 4G LTE network and now all the devices that we have on that. In May, we actually pulled the $35 price point from the marketplace. So that was part of the contribution of why we saw an acceleration of the dilution in the Internet ARPU. We have now since pulled that, so now the entry point is $50 stepping up to $80. So we've made that change, and I think that in itself will start to see improvement in the third quarter. But needless to say, the amount of devices and the volume within the 4G network we're very pleased with, with moving 1.2 million devices this quarter. And as you said, John, we are seeing folks who are coming off of their contracts on 3G moving over to the 4G and stepping down from their legacy pricing of the $60 and $70 price…

So Fran, do you expect total service revenue growth to continue to accelerate from here?

I believe we're going to be seeing continued acceleration of service growth.

John, this is Lowell. Just if I look back over my 20-some years on the Wireless side, every time we brought in new devices, we brought in new use cases, we saw nice expansion of the market. And I think that's just what you see going on here today. In some ways, it's similar to when we all went to family share plans. So there was a big concern over what ARPU was going to do. But we expanded the market nicely, great profitability, and I think that's exactly what's going on here now. And so we feel very good about the position.

Your next question will come from Simon Flannery of Morgan Stanley.

You talked about the Vodafone partnership and opportunities. Can you talk about the dividend potential, where the sort of negotiations stand and what sort of timing and type of payment we should be expecting there?

Sure. So I'll let Fran talk specifically about the dividend here. But I think that Vittorio's and my goal over the last 18 months have really been to try to turn the temperature down a little bit and to improve the bottom line of the relationship. So we've really focused -- because we knew LTE was on the horizon here, we started out by focusing on aligning the technology roadmaps, and that will go all the way through purchasing network equipment together as they're a little bit behind us because they don't have the spectrum for LTE, but they're beginning that ramp now. We also have heard very clearly from the large enterprise customers that combining the assets of Verizon business, meaning the global IP backbone and their data center infrastructure, and that's -- an exclamation point went on that with the Terremark purchase, that we could provide a global fix and mobile solution. So we've now -- we have teams that -- its one team made up of Verizon and Vodafone employees that face our top 50 accounts, and we're going to be expanding that very quickly. And there's a number of other smaller, but those are the main ones. Now regarding the dividend, we've been very clear that there will be a dividend. And why don't I let Fran just talk a little bit about the mechanics.

I think, Simon, at this point, I've made my comments on the dividend. I don't think there's really anything else to comment on, on the dividend.

Your next question will come from Tim Horan of Oppenheimer. Timothy Horan - Oppenheimer & Co. Inc.: Fran, I might've missed it, but could you comment on what you're seeing in terms of LTE speeds and maybe monthly over monthly data usage? And then on the margin front, you had a great sequential growth there, about 130 basis points on a consolidated basis. Could you talk about maybe the trends over the next few quarters and where you think you can be kind of longer term at this point? You've had almost a decade of restructuring in the business and a lot obviously upgrades to the infrastructure, and you're still substantially below where the margins used to be historically.

Yes, Tim, on the LTE speeds, we're seeing consistent from what we had disclosed before. We don't get into disclosure of any 4G LTE device usage at this point. Again, I think it's too early to really get a good average on what those speeds will be amongst all the different devices that we have there. As far as on the consolidated margin basis, I think I'll be consistent to say that our business strategy and what we disclosed back in January, I think it proves that we have proven that the strategy is working. We're expanding the market. We're growing our top line, and I think that the margin will follow here based on what Lowell just said where our main points of concentration are, which is the top line growth in all of our different business segments and taking cost out of the business.

Your next question will come from the Jason Armstrong of Goldman Sachs.

Maybe a couple of questions. First on capital spending. You obviously talked about flat this year. I'm just wondering from here if there are opportunities. Obviously, FiOS spending starts to wind down. Would you expect to sort of reinvest the declines in FiOS spending into either Wireless or Enterprise? Or do we continue to have sort of an outlook of flat to maybe even down capital spending as we look beyond the year? And then second, just on enterprise, maybe some of the SME trends. You have choppy macro data points from here. Did they give you any pause about the momentum you're seeing in that business as you look at the balance of the year?

Okay, I'll answer the first one, Jason. I'll let Lowell take the enterprise one. On the capital spending side, I think we'll just stick with 2011 at this point. And as you know, we spent $8.5 billion worth in the units. We're a total of $8.9 billion for the first half. And as I said back in January, we would be a little different this year because, historically, we've always kind of accelerated our capital expend through the year, and I was very clear at the beginning that said we would have an acceleration in the first half and then a decline because we felt that the capacity of EVDO was built out, and we still are very comfortable with that projection. So you should see that decline coming in the second half of this year. And I think at this point, we know that we still have LFA requirements on the FiOS build of about 1 million homes for the next 2 years. So I don't see any major change on premise past perspective, at least for the next 2 years out. And we said that we would commit on passing 18 million homes, and Lowell and I've said that we would stop there. And then based on penetration rates into the future, then we will make those decisions. So at this point, we'll stick with the flat for 2011, and we'll come back later and talk about the outer years.

On the enterprise question, Jason, and macro trends, I would love to be able to tell you that we see significant improvement in the overall economic outlook, but we can't really say that at this point. What we see is a shift. And whereas 2 years ago, you were seeing a lot of enterprise expansion, now we're actually able to capitalize on the cost reduction plans of these enterprises. So I think that's why cloud is picking up significantly for us as well as some of our other Strategic Services because the IT department is looking for an opportunity to take advantage of our scale and our applications and so they're shifting -- we're seeing some nice shifts of business. But as far as overall, do we see the economy coming out of this flat plateau? We say, no. I can't say that we see that.

Our next question will come from Michael Rollins of Citi Investment Research.

Just coming back to the Wireline side, can you help frame the margin opportunity for Wireline both over the next couple quarters and next few years especially in front of the labor negotiations. And maybe within that context you can give us an update there.

Okay, why don't I just make a comment. This is Lowell, on the labor side, Mike, and then Fran can add additional thoughts. I think the tone is good with the union so far. We have lots of dialogue. I think they've been very professional. We understand and I think -- I won't speak for them, but it's clear that when you see the core Access Line decline and you see the pressures on the Wireline business, that some things do need to change. And yes, we've asked for some changes in our work rules, and we've asked for them to consider coming on to the general employee and management medical plans. Those are probably the big issues. I think we're just coming into the time where we enter into serious negotiations as we get close to the August 6 date. And I'm optimistic that we'll be able to work something through that'll be fair and equitable to both sides.

Yes, Mike, on the margin side, I think I've been pretty consistent, and we've delivered consecutive margin improvement for the last 5 quarters. And I'll commit again that our business strategy is to continue to improve the Wireline margin through top line growth, as well as cost containments. And as Lowell always tells me, there's plenty of pots of gold out there to go after in the Wireline business. So we will continue to take cost out and really concentrate on those strategic revenue growth opportunities within the Wireline business, consisting of FiOS, the enterprise side and especially with the acquisition of Terremark. So I think our plan is there, we just have to execute on our strategy.

And can you disclose the ending net debt balance for Verizon Wireless?

For this quarter, it's about $6 billion.

Our next question will come from David Barden of Bank of America.

Two questions, if I could, real quick. Number one, even stripping out Terremark from the Global Enterprise, it was a nice, healthy tickup in 2Q versus 1Q, but we didn't really see that in the small medium business segment. Could you talk about the different dynamics that are driving those kind of businesses in different directions right now? And the second, if I could, just quickly on kind of the iPhone and LTE sales. Could you talk about what percentage was new to the base and what percentage was upgrades?

Sure, Dave. So with that, on the small business side, and I'm assuming that you're -- let me just get a clarification here. You're looking at the, really the SOHO business within the Wireline segment, which was actually down by 5.2% this quarter. And I think what's happening here is that we're seeing additional line loss in that segment. Now the actual Internet and broadband connection in that segment was actually positive for us this quarter, but we did see an acceleration of line loss. And I think what I would contribute it to is if you look at the national startup of small businesses, we are down on a national basis over 50% from where we were last year on startups. So I think it's an inflection of we don't have as much coming in the door to offset that line loss. And the line loss is not increasing but it's consistent. So I think we saw a little bit of a different dynamic in that 0 to 20 SOHO business, which created that acceleration there. But it's nothing that I'm overly concerned about. It's not a big portion of our portfolio. But it is definitely something that Lowell, I and the team are very focused on that we need to turn here in the future. And then on the iPhone LTE mix, the iPhone upgrade to new is pretty consistent with the first quarter, 22% to 23% new and the rest were upgrades.

Your next question will come from Phil Cusick from JPMorgan. Philip Cusick - JP Morgan Chase & Co: Wondering if we could dig in a little bit on the handsets. First, if you could talk about the smartphone mix of handsets overall. At the beginning of the year, we talked about that going up to 50%, and it doesn't look like it's going to quite make it. Do you see anything in the second half to sort of ramp up that upgrade rate to get smartphones higher? And then second, if you could help us on the LTE of 1.2 million, can you give us any kind of breakout between phones and data devices?

Let me take the first part of that one. I think, Phil, the handset and smartphone mix, we like the gross add mix that we see coming in here. We're in a roughly 60% kind of range. We are probably what I would view as maybe a quarter behind what we had talked about in January, primarily because we expected an iPhone 5 refresh sometime this summer. We don't know when the next one's going to come out. You'll have to ask Apple that, but we expect that probably sometime in the fall. And I think you'll see a significant jump there when we get to that point. On the LTE side, I can't tell you how pleased I am at how the device manufacturers have stepped up with all kinds of devices, and we're beginning to see, even in the machine-to-machine space, LTE modules because the latency is so much better than we have in a 3G environment. Our fourth quarter lineup is going to be very robust, and you've seen -- you've gotten a little bit of a peek at that through devices like the Samsung Charge. The screen density is significantly better than what we've seen in the past. So I think we're going to have, probably in my entire career, the best fourth quarter lineup of devices I've seen, which will shift that mix that you talked about.

And then, Phil, on the -- just the breakout of LTE. What I will say -- because I'm not going to break out individual devices here, but what I will say is if you take our 4G devices and our Apple device, it accounted for 69% of our net adds for the quarter. So that is definitely executed in the strategy that we laid out for our growth this year.

Our next question will come from Michael McCormack of Nomura.

Just maybe digging a little deeper on the Wireline enterprise trends. Can you give us some sense for what you're seeing at the customer level as far as demand goes and then also in the competitive environment, the pricing behavior among the bigger carriers? And then on the wholesale side, do you guys anticipate that you can get that revenue stream to something that's more flattish over time given the changes you've made? And then I guess, lastly, on the cash flow side, Fran, what should we be thinking about -- it's probably a little early to be discussing this, but the employee retirement benefits on a going-forward basis and then deferred taxes given bonus depreciation rolling off?

Okay, Mike, so on the enterprise side and the trends, I think what we're seeing is we're continuing to see improvement in our trends from an overall business perspective. And obviously with the Terremark acquisition, we've really put a sounding board out there for ourselves in the cloud space, and you saw that we split out that revenue of Terremark, which grew almost 30% year-over-year. So I think that strategy is there. What we're seeing, quite honestly, is a lot of enterprise customers are coming to us and asking us what solutions do we have in order to cut their costs. And obviously, a strategy around cloud is really the pivotal point of how we can cut enterprise cost. Now the major concern they obviously have is around the security of that cloud, and we think that being #1 in security and the portfolio that we have from our Cybertrust acquisition and what we just acquired from Terremark, we really do believe we're second to none in the marketplace as far as security expertise. So I think that is starting to build momentum here on the overall enterprise place and also on a global basis for us. On the wholesale side, as I said, this International Voice you saw this quarter, we declined down to 7.4% from where we were about 11% in the last 2 quarters. I think we'll continue to make progress there as we get back to an apples-to-apples comparison. And as I said before, I'm kind of bullish to had said if these trends continue, I do still think that in the fourth quarter, we could be back on a positive growth for the entire Wireline segment for us. And then, from a cash flow perspective and income tax and all that, that was all built into our forecast for free cash flow. As I said in the first quarter, we were low because of some timing-related issues. We came back to the range I gave, and I'm confident that with the decrease in our capital spend, we will deliver higher cash flow in the second half of the year.

Our next question will come from Jonathan Chaplin of Crédit Suisse.

Two quick questions, if I may. So as you strengthen your operating relationship with Vodafone, can you get all the benefits that there are to extract from that relationship just with this kind of a partnership? Or would there be merits to potentially think about combining these companies at some point in the future? And secondly, just going back to the smartphone question for a second. It looks like your share of the smartphone market is coming in a little weaker than we expected. I'm wondering how much you think AT&T offering a $50 iPhone sort of dampened your capture of the smartphone market. And it sounds like you think with the launch of an iPhone 5 and a strong lineup of devices in the fourth quarter, you should really see your smartphone share accelerate. I just want to see if -- make sure that, that's what you expect.

Okay, so there's a lot in there too, Jonathan. So I don't have a lot more to say on the smartphone versus what I said earlier. I do think it's about a quarter behind what we had talked about in January. So given that the delay of the iPhone 5 is more than a quarter, I think we've actually performed quite well. AT&T is a strong competitor, and they've done a lot of things to be a strong competitor. But I like porting ratios. I like our growth rate versus theirs, so I think what you're see is a result of a very dynamic market. Regarding Vodafone, look, I don't see a combination here. I think that we can do what we need to do. There's -- in our markets, they can do what they need to do. In their markets, we can leverage each other's scale, but I would not send any kind of messages here that something like that's immediately on the horizon. I think we need to show that we can do a good operating partnership here. And Vittorio and I see a ton of opportunities in that particular area, and we'll cross whatever bridges are ahead of us when we get to them.

Our last question will come from James Ratcliffe of Barclays Capital.

Two quick, if I could, one on Wireless. Are you expecting to see any churn impact from launching a situated pricing as customers become loathe to give that up by moving to another carrier? And secondly, can you talk through a little bit about what margin impact you're seeing from the growth of FiOS both leveraging the existing infrastructure regarding revenue and offsetting the higher operating costs associated with a larger portion of revenue coming from video?

James, let me take the question on tiered pricing, and then Fran can come back and talk about the margins. In my view is that tiered pricing is like gravity. The industry has to get there because there is not unlimited spectrum. And when you look at the utility of the devices that we offer and the video demand that is going to be hitting the devices, it's inevitable. Now each carrier will be in a slightly different position because of their spectrum holdings and their capacity on their networks. So I think over time, there may be some that hold out longer with unlimited, and I wouldn't be surprised if unlimited comes back in and out from a promotional perspective for carriers to balance growth. But in my view, it is -- as I said, like it's inevitable. So do I expect to see some churn impacts? Sure. There will be some users that are very high users that will want to move between carriers to find whatever opportunities they can to continue that. But our strength has always been the best network and the best customer service, and at 2 gigs, well over 95% of our customers are underneath that demand. So I don't think there will be tremendous disruption.

Okay, and then, James, on the FiOS margin, what I will say is that we will continue to make improvements operationally in the FiOS, whether it be on the capital cost of passing a home and a capital cost of connecting the home. And then operationally, we are still performing very, very well compared to core especially around repair and maintenance because the FiOS network operates pretty efficiently. So I think overall, what I will disclose is that FiOS margins continue to improve. I think it's based on 2 things. One is we are very concentrated on the top line growth of our revenue per customer. We have launched Flex View. We've re-bundled where you can build your own bundle now, and we're seeing some nice uptick in people varying whether they want higher speed or less bundling in TV packages and now also with our forthcoming release of our connected home product around security and energy monitoring and electricity and all. So I think it's twofold. It's the operational cost efficiency and building the top line growth of FiOS.

Thanks to all of you for joining us this morning. Brad, that concludes our call.

Ladies and gentlemen, that does conclude the conference call for today. Thank you for your participation and for using Verizon conference services. You may now disconnect.